Nama : Talitha Alda Nirmala

NIM : 042011233140
Kelas : H – Manajemen Keuangan 1

Derivatives for Investment Risk Management

Dr. Jacinta Chan, PhD in Financial Statistics

1. What Are Derivates

Derivtaes are financial instuments that derive their values from the value of
underlying asset (physical commodity or financial instrument), like agriculture
commodities, metal commodities, foreign currency commodities, energy
commodities, stock index, interest rate, and bond.
- Forward Contracts : Over the counter (OTC) agreement contrats between buyer to
buy and seller to sell underlying asset at a future date, at a price determined today.
- Futures Contracts : Standardized and exchange traded agreement contracts
between buyer to buy and seller to sell an underlying asset at a future date, at a
price determined today.
- Option Contracts : Provide the holder the right but not the obligation.
- Swap Contracts : Over the counter (OTC) agreement contracts between buyer and
seller to swap/exchange cashflows of underlying assets at periodic intervals.

Exchange Traded Futures Contract Specifications

- Futures Contracts : Standardized and exchange traded agreement contracts
between buyer to buy and seller to sell an underlying asset at a future date, at a
price to determined today.
- Standardized : Underlying asset, contract size, quality, delivery date, delivery
place
- Exchange : Liquidity, secondary market, competitive price discovery through
demand and supply, eliminate other party counterparty risk by novating the
counterparty risk to the clearing house of the exchange. The clearing house
minimizes the risk of default by requiring an initial margin and daily market to
market any profit/loss according to the daily settlement price.

Options
Option Contracts : Provide the holder the right but not the obligation to buy or sell the
underlying asset at a predetermined price. A call option provides the right to buy, and a put
option would provide the right to sell.

Over The Counter Swaps

- Currcency Swaps : 2 parties exchanging one currency for another
- Commodities Swaps : 2 parties exchanging cash flows based on an underlying
commodity index or total return of a commodity in exchange for a return based on
market yield
- Equity Swaps : 2 parties exchanging cash flows based on different equity indices

Trading and Clearing of Derivatives

- Exchange Traded Derivatives
- Trading Methods : Open outcry and Electronic Exchange
- Standardized
 - Secindary Trading
- Clearing House

2. Purpose of Derivatives
- Risk Management : Fully or partially hedge the price risk of existing portfolio
- Create Synthetic Positions : Using features or options and secure the remaining
fund in cash to earn interest.
- Arbitrage : If there are any temporary mispricings between futures and equity
markets, those are fantastic opportunities for riskless profit.
- Short the Market : Stock index futures are wonderful instuments to short the
basket of equity stocks instantly.
- Enhance Fund Managers’ Returns : Fund managers can write puts and calls on the
underlying which they hold to enchance their portfolio returns.

3. How Derivatives are Being Used As Risk Management Tool

- Hedge against price fluctuation
- Adjusting portfolio beta

Stock Index Futures

Is an exchanged traded futures contract between 2 parties to deliver and take delivery of a
basket of index stocks at a fixed future date at an agreed price. Stock index futures contracts
are cash settled which means that on the last day of trading, any outstanding contracts are
settled by reference to the price of the underlying stock index.

Reasons to Use Stock Index Futures

- Easy access to the overall broad market at lower costs
- Leverage
- Lower Brokerage Cost
- More liquid, ease of exit
- Possible to short sell stock index futures
- Market Price Risk Management (Hedging Purpose)

Stock Index
Stock index is used as a barometer for/as the market. IDX30 is calculated based on Market
Capitalisation and % of free float.
Market Capitalisation = number of shares x current market price.

Stock Index Futures

Is a Contract to Sell or Buy a Basket of Stocks at a Fixed Future Date. Example: A portfolio
manager can sell a stock index futures contract to hedge his portfolio of stocks. He can sell 1
FKLI Futures Contract today to hedge his portfolio of FBM30 Malaysian stocks Worth
RM82,000 anytime to 31 October.

Futures Fair Value

Fair Value is the Theoretical Price of the Futures.
Futures Fair Value = Spot Price + Cost of Carry
Cost of carry include time to maturity, interest rates, storage costs less yield on the cash
commodity.
Ft= S0 + S0(r + c - y)t
Ft = S0 (1 + r + c - y)t

Ft= S0 + S0(r + c - y)t

In the case of stock index futures, there is no storage cost, so c is dropped off.

Ft= S0 + S0[(r – y) x t/365]

F=S[1 + (r x t/365) - (y x t/365)]

Benefits of Using Stock Index Futures

 Knowing with Certainty that you sold the underlying asset (30 FBM KLCI stocks) at
a certain price (1645), even though the underlying asset may fall (or rise);
 Leverage – Using RM4,000 margin, you sold a contract worth RM82,250.

Hedging Away Risk

Hedging is taking a futures position opposite to the current physical position held. Hedging
using Futures is a way of limiting the risk that arise from large price fluctuations.

Hedging a Current Physical Position

Take a futures position that is opposite to the position that you already have in the cash
market.
Example:
An investment fund manager with a portfolio of shares can hedge his long shares position by
selling the equivalent amount of stock index futures contract so that:
 If the market falls, what he loses in the sharemarket is offset by the gain he made in
the futures market or
 If the market goes up, what he gains in the share market is offset by the lose he made
in the futures market.

4. Who Trades Derivates

- Hedgers : Hedgers are players whose main objective is risk reduction. They are
usually businesses who want to offset exposures resulting from their business
activities.
- Speculators : Speculators are players who main objective is to make profit from
the markets. They are players who establish positions based on their expectations
of future price movements. They take positions in assets or markets without taking
offsetting positions, expecting market to perform according to their expectation.
- Arbitrageurs : Arbitrageurs are players whose main objective is to profit from
pricing differentials mispricing. They closely follow quoted prices of the same
asset/instruments in different markets looking for price divergences. Should the
divergence in prices be enough to make profits, they would buy in the market with
the lower price and sell in the market where the quoted price is higher. They also
arbitrage between different product markets. For example, between the spot and
futures markets or between futures and option markets or even between all three
markets.

Speculating : Speculators do not own or use the cash commodity. They are motivated to take
position and risk their capital for opportunity to profit.

Speculators :
Types of Speculators
Scalper: Trades heavy volumes, small profits,rarely hold overnight position.
Day Trader: Trades intraday positions, medium volumes, slightly larger profits, rarely hold
overnight position.
Position Trader: Trades trends (take a view of the market in the medium and long term hold
positions for days, weeks and months when prices are moving in his favour.

Arbitraging : Arbitraging involves simultaneous purchase in one market (eg the physical
market) and sale of identical amount in another market (eg the futures market) at a higher
price to profit from price discrepancies.

Arbitrage : When Futures is higher than Fair Value, Arbitrageur sells Futures and buys
Cash/Physical To make “riskless” profit when the futures converges to cash on expiration.

Hedge Imperfections
Basis risk can occur when the gain and loss in the futures and cash markets do not offset
exactly because futures and cash market do not correlate perfectly.